Life Science Stocks Aren’t Completely Hopeless, But …

by James Brumley | February 21, 2013 9:24 am

Philosophically speaking, medical technology companies should be some of the market’s best-performing stocks. After all, it’s not really a cyclical business, and price tags are rarely a stumbling block when insurance companies, the government and individuals with health-related challenges are footing the bill.

In reality, however, shares of life-science technology names like Affymetrix (NASDAQ:AFFX[1]) and Illumina (NASDAQ:ILMN[2]) are struggling, reflecting their underlying companies’ struggles.

Thus, investors rightfully are wondering when — or even if — the life science group can snap out of its funk, and what it’s going to take to make it happen.

Life Technologies Is a Microcosm

On the surface, Life Technologies‘ (NASDAQ:LIFE[3]) 8% share decline Wednesday stemmed from the fact that Thermo Fisher Scientific (NYSE:TMO[4]) is backing out of its offer to acquire LIFE for a little more than $11 billion. The reason? A possibly excessive valuation in the shadow of an even-bigger roadblock. Even with Wednesday’s 8% dip, Life Technologies shares still are up 18% for the year, making the stock more expensive than the industry average on both sales and earnings bases.

The real stumbling block for Thermo Fisher, however, isn’t the frothy valuation, but the fact that the forward-looking valuation doesn’t factor in a very likely government sequestration.

Barring any changes between now and March 1, the government will automatically mandate budget cuts — a sequestration — that will impact nearly all of its programs. These cuts include spending on medical equipment, drug development technology and even academic-based projects … a salvo lobbed right into most of Life Technologies’ markets.

Or, if this makes the point better, Thermo Fisher is expecting the sequestration to materialize even though Life Technologies isn’t. If Thermo Fisher’s guess is right and it bought LIFE anyway, it could end up being a very unfruitful purchase. A sequestration likely would mean a slight decline in this year’s sales rather than the respectable 4% increase the company is currently projecting for 2013.

Not Just Thermo Fisher, and Not Just 2013

Were it just Thermo Fisher worried about looming budget cuts, or just Life Technologies alarmingly unworried about them, traders might be able to simply chalk it up to an isolated scenario that didn’t apply to any of the other names in the life science group. But it’s not. Many of the companies in this sliver of the market are worried, and for good reason.

Illumina is one of those other names that’s concerned about the impact of tightened federal government purse strings. Although the company has yet to hit a revenue headwind, Illumina CEO Jay Flatley said during the company’s last earnings call that “… we’re surprised, actually, how unaffected (academic customers) seem to be by any of the macro conditions or the sequestration risk that still hangs out there. Obviously, we’ve been very pleased by that response.”

Although pleased thus far that a sequestration hasn’t crimped sales — nor has a broad economic malaise — Illumina clearly knows that risk is on the horizon. Indeed, about half of its revenue is driven by academic institutions, which will be among the first to lose significant funding from the cuts. The nation’s colleges and universities do about a third of the scientific research funded by the government.

All told, if the government sequestration is allowed to fully unfurl, it would reduce $85 billion worth of spending in 2013 and take $1.2 trillion worth of spending off the table over the next 10 years.

On the Other Hand

To be fair, while a government budget cut will have at least some impact on all companies in all sectors, that’s not to say every life science name is in grave danger of the sequestration right now. Indeed, many of these organizations primarily serve the private market, and/or have a strong overseas presence. They won’t under the same duress as, say Illumina or Life Technologies.

Take Bio-Rad Laboratories (NYSE:BIO[5]) for example. BIO has posted strong revenue growth in four of the past five years, and strong income growth in a different four of the past five years. The current year should be even better on the revenue front, too, fueled at least in part by the recent acquisition of antibody maker AbD Serotec.

The compelling part about BIO, however, isn’t a strong growth trend or a hot product in a key market. It’s the fact that more than two-thirds of its business is driven overseas, where the ripple effects of a U.S. government sequestration aren’t felt. Bio-Rad is the exception to the norm, though.

For a whole host of reasons (even besides the budget cuts), this group is struggling. The core reason, however, is simply lackluster sales and inconsistent profits. Affymetrix, for instance, is still bleeding revenue, and hasn’t turned a profit in its five-year existence even though it’s been up and running for six years. The sequestration might not make that matter worse, but it’s certainly not going to help.

Bottom line? This isn’t a completely hopeless group right now, but choose very, very carefully.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.